In a recent series of articles I looked at how to prepare for a recession whilst investing in ASX shares. A key component of this was working out and understanding your cash flow needs. In other words, preparing a budget. Preparing a budget is important in the good times and even more so in the tough times.
How to make a budget
Preparing a budget can be as simple or complex as you want to make it. There are some great templates and calculators out there if you want to keep it simple. But when investing in ASX shares, there are a few more factors to consider.
Make sure that you factor the following into your budget: needs vs wants; emergency fund deposits; annual expenses; and amounts for saving and investing.
A key concept when preparing a budget for ASX investing is opportunity cost. A dollar spent on a consumable item like coffee is gone forever. However, it may not just be a dollar. If that dollar was able to be invested in ASX stocks and earn a 10% return, it would be worth double in 7.2 years.
This isn’t the only way that each dollar can be different. A dollar saved is worth more than a dollar earned. Why? Because of the tax man. If your taxable income is more than $180,000, you are on the top marginal tax rate of 47% (including the Medicare Levy). Saving $1,000 is the equivalent of earning $1,887 before tax.
Margin of safety
Everyone will at a minimum know someone who has seen their income impacted by COVID-19. This is a great example of why you need to have a margin of safety built into your budget. A margin of safety is a buffer of how much your income can drop before you “break even” on your necessary spending.
Although COVID-19 is a black swan event, there are many instances where you may see a spike in expenses or drop in income. Your employer could go bankrupt, a family member could have a health issue or you may want to change career.
A margin of safety will allow you to hold your stocks through an unforeseen event, ensuring that you don’t miss out on the handful of amazing days that generate most of the stock markets returns. If you were forced to sell Afterpay Ltd (ASX: APT) at the bottom on 23 March, you would have missed out on the 147% rebound through to Easter.
A margin of safety is even more important where you have collateralised debt (such as a mortgage) or any high interest or high penalty amounts owing. Keeping your house and avoiding unnecessary costs can be critical to preserving your wealth in a recession.
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Lloyd Prout owns shares in Altium Limited and expresses his own opinions. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of Altium. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.